CWS Market Review – February 24, 2012

Remember way back when the stock market used to fluctuate? And by “way back,” I mean six months ago.

Nowadays, the S&P 500 barely moves. Just look at what happened on Tuesday, Wednesday and Thursday of this week. In order, the S&P 500 gained 0.07%, lost 0.33%, and then gained 0.43%. Dear Lord, this is the financial equivalent of watching paint dry!

Wall Street Is Finally Calming Down

Perhaps the biggest unreported story on Wall Street is the stock market’s dramatic falloff in volatility. The S&P 500 still hasn’t had a single 1% drop this year. Last year, it happened 48 times. The Volatility Index ($VIX), which is often called the “Fear Index,” closed Thursday at 16.83; this was its lowest close in more than seven months and just half of where it was just three months ago. The evidence is clear—Wall Street is calming down.

Between you and me, I don’t mind this lack of volatility at all. All it means is that the bandwagon crowd has lost interest in stocks. Trading volume is at its lowest level since 1999. I recently noticed that E*Trade Financial ($ETFC) said that their trading volume was down 20% from a year ago. TD Ameritrade ($AMTD) said their volume was off by 17%. Clearly, lots of folks are sitting this rally out.

Alongside the market’s newfound stability, the big development for investors is the reemergence of risk-taking. It’s hard for me to overstate how important this is. In fact, we can see evidence of investors’ growing appetite for risk in both the stock and bond markets.

First, let me explain that 2011 was a giant exercise in investors sticking their heads in the sand. This may sound odd but last year’s stock market really wasn’t that bad—outside of the major exception of a three-day stretch in August when the S&P 500 lost 11% which coincided with S&P’s silly downgrade of U.S. Treasury debt.

Not only did that move not hurt Treasury prices, but it sparked a massive run on Treasury debt. The Long-Term Treasury ETF ($TLT) shot up 20% in two months. This shift was mirrored in the stock market by investors dashing for any stock that paid a generous yield. You may recall that our Buy List yield king, Reynolds American ($RAI), had an outstanding year in 2011. Investors wanted those rich dividends.

Basically, investors got scared by the euro crisis and debt-ceiling debate, and they rushed towards the lifeboats. The result was that any asset with an ounce of risk (or really, perceived risk) got tossed aside. Now that it’s obvious that events in Europe, as terrible as they are, won’t bring us down into the abyss, investors are rediscovering those higher-risk assets. Even high-yield bonds are doing well. The equation will be higher long-term Treasury yields. Small-caps and cyclical stocks will lead a cautious rally, and gold will also do well.

(As a side note, the yield on one-year Greek debt jumped to 750% this week, which is the market’s way of saying that not everyone is going to get paid.)

The S&P 500 finished the day on Thursday at 1,362.46 which is just 0.15 points shy of its post-crash high close from April 29, 2011. This is one of the greatest three-year bull markets in Wall Street history. But valuations by any reasonable metric are still very good.

Let’s break down some of the math: The consensus on Wall Street is that the S&P 500 will earn $104.40 this year. Using a P/E Ratio of 16.4, which is the average over the last 50 years, gives us a value of 1,712 for the S&P. That’s more than 25% higher from where we are today. I’m not predicting that’s where we’ll be by year’s end. I’m just showing you how favorable stocks are compared with bonds.

But it’s not all sunny skies. My biggest concern is that guidance from many companies hasn’t been very good. I’m also surprised that investors continue to favor Treasury Inflation Protected Securities so strongly. On Thursday, the yield on the 10-year TIPs got down to 0.3%, which matched an all-time low. That could be a sign that economic growth will continue to be sluggish. As I mentioned last week, the jobs report will be a major factor in determining corporate profits.

Medtronic’s Disappointing Earnings

Our only Buy List earnings report this week came from Medtronic ($MDT) and it failed to impress me and most everyone else. After charges, the company reported fiscal third-quarter earnings of 84 cents per share, which was in line with Wall Street’s consensus.

The problem for Medtronic is that their spine and defibrillators businesses aren’t doing well. The CEO was very frank about the problems there and he said that a change may come soon, but I doubt that will include a sale. The market didn’t like Medtronic’s earnings report, and the stock lost 5% this week.

On the plus side, the rest of the business is doing fairly well. Medtronic also narrowed its full-year EPS range to $3.44 to $3.47. The previous range was $3.43 to $3.50. Since there’s just one quarter left in the fiscal year, this range implies earnings of 97 cents to $1 per share for the current quarter.

When Medtronic reports earnings in May, they’ll include guidance for next year as well. Frankly, I’m disappointed by Medtronic’s performance, and I want to hear what they have to say about the coming fiscal year. For now, I’m keeping my buy price on Medtronic at $40 per share.

In other Buy List news, William C. Weldon, the CEO of Johnson & Johnson ($JNJ), announced his retirement. This is another large healthcare stock that should be doing better than it is. I’m happy to see that a change is in the works.

I should explain that with our investment strategy, we often see “dents and scratches” in our companies. After all, that’s what causes the bargain prices. The issue for us is, “Are these problems fixable or not?” In the case of the stocks on the Buy List, I believe that any blemishes are transitory problems. The issues can often be resolved through time and attention (like we saw at Nicholas Financial). That’s why I urge investors not to get overly concerned by negative news on one of our Buy List stocks. These are very sound companies, and we’re on track toward beating the S&P 500 for the sixth year in a row. If you’re looking to add new money to any positions, both Oracle ($ORCL) and Fiserv ($FISV) look especially attractive at the moment.

That’s all for now. The big news next week will be the revision to the Q4 GDP report on Leap Day. Then on Thursday, March 1st, the ISM Index for February will be released. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Named by CNN/Money as the best buy-and-hold blogger, Eddy Elfenbein is the editor of Crossing Wall Street. His free Buy List has beaten the S&P 500 seven times in the last eight years. (more)